Home Finance Making Clear the Costs of a Hard-Brexit

Making Clear the Costs of a Hard-Brexit

by internationalbanker

By Rick Watson, Head of Capital Markets, The Association for Financial Markets in Europe (AFME)

 

 

 

August provides a break in the political cycle, an opportunity to evaluate progress made and new challenges to come. It has been more than a year since the United Kingdom voted to leave the European Union (EU), but several important milestones have already passed: in March, the UK triggered Article 50, formally kicking off the two-year timeline until it leaves the EU; both France and the UK held elections with important implications for the negotiating process; the UK government introduced the European Union (Withdrawal) Bill; and Brexit negotiations have formally begun. Over the next 18 months, the terms of the future relationship between the UK and the EU27 will be determined. During this period, it is imperative that policymakers know the potential costs of a hard-Brexit, so that they understand how their decisions could affect the financial-services sector and beyond.

The relationship between the UK and the EU27 is deeply connected across many sectors. This is perhaps nowhere more apparent than in the financial-services sector. European capital markets are the engine of the economy, providing the capital and investment that enable EU businesses to grow, infrastructure to be built, and households to save for their futures. While uncertainty surrounding the negotiations remains, what is clear is that a hard-Brexit could have a significant impact on the ability of Europe’s capital markets to continue serving businesses.

In order to help understand the potential costs of a hard-Brexit, AFME recently commissioned the Boston Consulting Group (BCG) to investigate the possible impacts of a hard-Brexit on European end users of wholesale banking and capital-markets services. In the course of preparing the report, BCG surveyed treasurers and CEOs from 62 European corporates, small and medium-sized enterprises (SMEs) and investors, along with 10 industry associations that represent a wide range of companies and sectors.  The final report, written in partnership with Clifford Chance, suggests that a hard-Brexit would result in significant disruption to Europe’s capital markets and the businesses that rely upon them.

How are the end users of Europe’s wholesale markets preparing for a post-Brexit EU?  

Businesses and investors are the end users of Europe’s capital markets, and a hard-Brexit, which would have significant impacts on the capital-markets industry, would undoubtedly indirectly affect them. However, not all end users are concerned and may not be preparing for an interruption to their current banking relationships. 

Large corporates and investors are most worried about the direct impacts that Brexit may have on their businesses such as: barriers to trade, movement of labour and increased compliance and customs costs. Their key concerns relate to the potential impact on risk-management and disruption to existing contracts. However, they generally assume that banks will mitigate any indirect impacts that affect their access to wholesale banking-related services. In reality, the costs of a hard-Brexit may impact the ability of banks to continue providing services to their clients—and SMEs may be the hardest hit.

SMEs are more likely (than large corporates) to find their access to wholesale banking services restricted, and the cost of making adjustments—such as forming new banking relationships—could be material for them. SMEs tend to choose a local bank and stay loyal to them. In fact, 60 percent of SMEs currently use only one bank for their business banking because of higher costs and greater difficulties than experienced by large corporates when building new relationships.

In the event a local UK bank chooses not to establish a subsidiary in the EU27, or that a hard-Brexit results in banks having to change their services for existing customers, developing a new banking relationship could be time-consuming, taking anywhere from six months to replicate what SMEs currently do in the UK.

According to our report, SMEs are also the least prepared to deal with such disruption. This could have profound implications for Europe’s future growth. Europe’s SMEs are the backbone of the economy, making up 99 percent of companies in the EU, and providing 67 percent of employment. That amounts to approximately 58 percent of gross value added in the non-financial economy.

What are the potential costs of a hard-Brexit? 

A hard-Brexit would mean the end of passporting between EU27 countries and the UK. In such a scenario, the cost to the financial-services sector would be significant—in terms of transferring bank operations and capital to new entities, as well as restructuring costs, and ongoing higher capital needs due to increased fragmentation. These costs represent potential indirect costs for the end users of wholesale markets: businesses and SMEs.

A hard-Brexit could mean that an aggregate €1.28 trillion of bank assets needs to be re-booked from the UK to the EU27 in a worst-case scenario. Notably, these assets are supported by €70 billion or approximately 9 percent of (Tier 1) equity capital of the banks affected.

Capital-market activities most likely to be impacted by a hard-Brexit are securities and derivatives trading. In the event of a hard-Brexit without the ability to passport, UK-based banks may need to move a significant portion of securities and derivatives trading to the EU27. Trades with EU27 clients now booked in the UK are estimated to amount to €380 billion in risk-weighted assets, or €1,100 billion in trading assets, representing approximately 68 percent of all trading with EU28 clients booked in the UK. This business is supported by €57 billion of bank equity capital. The cost of the associated restructuring could be as much as €15 billion.  

Another potential area of concern for markets is the call by some EU political leaders for all euro-denominated contracts to be cleared in the eurozone. This would separate euro-denominated contracts from non-euro contracts held at central counterparty clearing houses (CCPs) located in the UK, and possibly other non-EU locations. Should the approximately €83 trillion of outstanding euro-denominated interest-rate contracts in the UK be moved to the EU27, an additional collateral requirement of approximately €30–40 billion, or 40 to 50 percent, would be imposed on the European banking sector. This cost will need to be borne by banks and/or their clients. Banks and other financial counterparties would have to fund this with high-quality collateral that is already in scarce supply.

Clearly, the impact of a hard-Brexit will present material costs for the banking sector. These costs could be, in part, passed onto the end users of the wholesale markets industry—representing a substantial, and unexpected, Brexit-related cost to businesses, ultimately impacting the wider economy and growth. 

What can policymakers do to improve economic outcomes?

Clearly there is work to be done to mitigate the costs to financial services and the indirect costs that businesses will incur in the event of a hard-Brexit. These indirect costs for businesses could be eased by ensuring continuity in their access to wholesale banking. In this respect, several policy recommendations would be key.

First, prompt action is required to provide the necessary clarity that these contracts will continue after the UK’s exit from the EU. Both the UK and the EU have a shared interest in ensuring that the issue of contractual uncertainty on the stock of cross-border financial contracts is addressed at an early stage as part of negotiations to avoid any chilling effects for business, additional costs for customers and disruptive economic effects for the UK and the EU.

Second, in preparation for a hard-Brexit, some banks will need to form new legal entities and re-document their client relationships; policymakers should therefore provide regulatory support and sufficient time for these processes to occur.

Next, transitional arrangements should be put in place. It is crucial that clarity is provided as soon as possible on a transitional period. Transitional arrangements are required to avoid cliff-edge scenarios, support economic growth, and maintain market efficiency and financial stability. Absent an early agreement on transitional arrangements, businesses will be forced to make sub-optimal decisions and may further delay investments. Banks are conducting extensive planning and putting in place arrangements to minimise disruption to their businesses and clients. However, additional time is required to adapt to the post-Brexit framework and to minimise disruption for end users of financial services.

Finally, alternative funding schemes will need to be established to substitute for the loss of funding options that UK companies will face from no longer having access to the European Investment Fund (EIF) and the European Investment Bank (EIB).

Brexit presents an unprecedented challenge for the EU27 and the UK. The cost to businesses, the economy at large and citizens should therefore not be underestimated. The negotiations over the next 18 months will be crucial, but the clock is ticking, and to avoid disruption, business needs clarity as soon as possible.

 

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